Traditional and Roth IRAs have different tax considerations

Planning for retirement is an essential, and often overlooked, process that everyone should consider. With so many available retirement plan options, how do you choose the best one for you? Understanding the features of each retirement plan will allow you to select a plan that will be most beneficial in the future.

Individuals can establish a traditional Individual Retirement Account (IRA) or a Roth IRA account. These plans are subject to different contributions limits and restrictions.

A major difference between a traditional IRA and a Roth IRA is the timing of the taxation of contributions and distributions.

Contributions made to a traditional IRA may be deductible for tax purposes. Taxpayers have until the April tax deadline of the following year to make contributions. For example, taxpayers can establish a traditional IRA account by the April 2008 tax deadline, and they would still be able to deduct the contribution on their 2007 tax return.

For 2007, individuals may contribute up to $4,000, and for the 2008 tax year, you will be able to contribute up to $5,000. If you are at least 50 years of age, you are allowed to make an additional catch-up contribution of $1,000 to either type of IRA. But be careful, a 6 percent excise tax penalty will be imposed on contributions over the limit.

The amount of deductible contributions into a traditional IRA is limited for taxpayers with high adjusted gross income (AGI). For example, in 2007, deductible contributions to an IRA will be reduced for married taxpayers filing joint returns with a modified AGI between $83,000 and $103,000. Limitations also apply to other filing status categories (such as married filing separately, single and head of household) and care should be taken to follow the rules.

Distributions from traditional IRAs are subject to income tax because the contributions were deducted for tax purposes. Once you reach the age of 70 1/2, you must begin to receive required minimum distributions (RMD) from the traditional IRA. You will have until the April tax deadline of the following year to start receiving this required distribution.

Early distributions made before you reach 59 1/2 years old are subject to a 10 percent penalty. However, rollover distributions into another IRA account are not taxable as long as the rollover is made within 60 days. There are some limited exceptions to the 10 percent penalty, in such cases as paying medical insurance premiums of unemployed individuals, certain education expenses, and certain first-time homebuyer expenses.

Roth IRAs have the same contribution limits as traditional IRAs. However, contributions made to Roth IRAs are not tax deductible, and contributions are not allowed if a taxpayer’s modified AGI exceeds certain ceiling amounts (such as $166,000 for 2007 married filing jointly taxpayers). In contrast to traditional IRAs, you can continue contributing into a Roth IRA after the age of 70 1/2.

Qualified distributions from a Roth IRA are not taxable. You must make contributions into a Roth IRA for five years before receiving qualified distributions. Distributions are qualified if the individual is at least 59 1/2 years in age, if the distributions are made to a beneficiary after the individual’s death, if the distribution relates to the individual’s disability, or if the distribution will be used toward qualified homebuyer expenses.

In Hawaii, distributions from pension plans that are funded by employers are exempt from state tax. Since traditional IRAs are not funded by employers, the distributions may be fully taxed for Hawaii purposes.

Ken Kretzer is a senior tax manager for the Honolulu office of Grant Thornton LLP. He can be reached at Kenneth.Kretzer@gt.com